Earnest Money and Income Tax in India..!



 By Mr. M.K Agarwal, CA, Mahesh K Agarwal & Co

You do not have to pay income tax on earnest money received from a failed deal. But, there are other income tax implications you should be familiar with, says Mr. MK Agarwal, CA at Mahesh K Agarwal & Co

When you buy or / sell a tangible asset, there is usually some earnest money given by the buyer before he arranges for the full payment. This can range from Rs. 5,000 to Rs. 10,000 for a used car to a couple of lakhs of rupees for a real estate transaction.

The payment is meant to seal the deal &  the rules of arrangement are simple. If the buyer backs out, the earnest money given to the seller is forfeited. If the seller changes his mind, he gives back double the amount to the buyer. To ensure that both the parties play fair, there is typically an intermediary who is known to both.

In normal circumstances, any amount received as advance for the purchase of an asset is a revenue receipt & is taxed in the year that it is received. What happens if the money is received from a buyer who fails to keep his commitment &  the deal falls through Will the forfeited amount become the income of the seller and will he have to pay tax on it Under which income head will the amount have to be declared in the tax return form

As per Section 51 of the Indian Income Tax Act,1961, if the owner of an asset has received money by forfeiting any advance money for the asset, this amount will be deducted from the purchase price of the asset. This is the cost for which the asset was acquired or / its fair market value (if the property was purchased before 1 April 1981).
M.K Agarwal

Capital Gains Tax..!

Suppose you bought a property for Rs. 10 lakh nearly 15 years ago, and 2 years ago, you decided to sell it for Rs. 40 lakh.

The deal was struck and the buyer gave you earnest money of  Rs. 2 lakh, but later backed out.The  Rs.2 lakh will be treated as capital receipt &  you will not be taxed in that year, but the amount will be deducted from the purchase price of your property when you sell it in the future.

In this case,the purchase price will be taken as Rs. 8 lakh ( Rs. 10 lakh Rs. 2 lakh).

In some cases, the deduction of earnest money from the cost price of the asset pushes up the capital gains tax of the owner substantially.

In the example (How much income tax... ), the owner would not have had to pay any tax had he not forfeited the earnest money. The indexed cost of acquisition without deducting Rs. 50,000 from the cost price would have been Rs. 8.3 lakh. One would be better off including the earnest money in ones income from other sources &  paying tax on it. Is this possible The law is silent on this because the earnest money is a capital receipt, not income.

Also, the seller must know that this is a one-way street. If you backed out of the
deal & paid the buyer Rs. 2 lakh compensation, it would be treated as a capital loss & not added to the purchase price of the property.You can claim tax benefit on this only if you were in the business of sale &  purchase of the property.

In such a case, the loss due to forfeiture would be treated as a revenue loss.

Earnest money is usually a very small percentage of the total value of the transaction. But, sometimes it can be higher than the cost price of the asset. Under Section 48 (read with Section 51), if the amount forfeited is greater than or / equal to the cost of acquisition, the cost of the asset will be taken as nil.

In one such case involving Mrs. Sunita N Shah (2005) 94 ITD 492 (Mumbai), the forfeited amount was higher than the cost of acquisition. In such cases, the excess amount is considered capital receipt and is not chargeable to tax.

The same ruling was given in the case of Travancore Rubber & Tea Co.Ltd (2000) 243 ITR 158, wherein the Supreme Court ruled in favour of the assessee.

Tax Impact on Buyer.!

In case the buyer defaults &  the earnest money is forfeited, he will not be allowed to show it as a capital loss. This was the verdict in the case of CIT vs Sterling Investment Corporation Ltd (1980) 123 ITR 441. However,if the seller fails to honour the deal & pays the buyer double the compensation, this will be treated as capital gain because it amounts to relinquishment of a right by the buyer.In the case of CIT vs Vijay Flexible Container (1990) 186 ITR 693, it was held that giving up the right to obtain conveyance of immovable property amounts to transfer of a capital asset.

What happens if the advance money was for the purchase of a commercial property Can the loss be treated as business expenditure incurred by the purchaser The amount can not be claimed as revenue expenditure.

In CIT vs Jaipur Mineral Develop Syndicate (1995) 216 ITR 469 (Raj), it was held that if the payment is made for the pupose of acquiring a capital asset, the amount lost upon forfeiture will not be considered as revenue loss though the amount may not have the same consequence or / character in the hands of the recipient or beneficiary.

How Much Income Tax Does Seller Pay?

Mr. Murugan bought plot of land in January 1987 for Rs.2 lakh. He agreed to sell it to Mr. Suresh in January 1998 & received  Rs. 50,000 as earnest money. However, Mr. Suresh backed out and his  Rs. 50,000 was forfeited. Mr. Murugan sold the land on 1 January 2009 for Rs. 8 lakh to Mr. Wan. Heres how his gains will be taxed:

Purchase Price:  Rs. 2 lakh

Earnest Money Received: Rs. 50,000

Deemed Purchase Price: Rs. 1.50 lakh

Indexed Cost (in 2008 - 09 ):  Rs. 6.23 lakh

Selling Price: Rs. 8 lakh

Capital gain: Rs. 1.77 lakh

Tax payable: Rs. 35,400 ( 20 per cent)

About the author..!

The author  MK Agarwal is a CA (chartered accountant) and Senior Partner at Mahesh K Agarwal & Co and can be reached at mkcacs@gmail.com

Contact:

Mahesh K Agarwal & Co..!
Email:  mkcacs@gmail.com

MAHESH K.AGARWAL & Co. Chartered Accountants

Mahesh K. Agarwal & Co. was established in the year 1983. It is a leading chartered accountancy company rendering comprehensive professional services which include audit, management consultancy, tax consultancy, accounting services, manpower management, secretarial services etc.

Fellow Member of Institute of Chartered Accountants Of India and Institute of Company Secretaries Of India, Commerce Post Graduate from University Of Rajasthan(Jaipur) and Bachelors of law from Delhi University.

Mr. M.K. Agarwal was enrolled as a member of the ICAI in 1983 and has to his credit an experience of more than 25 years in almost every facet of the accounting profession. He was an elected member of the Northern India Regional Council of the Institute of Chartered Accountants of India for nine years from 1990 to 1999 and has been a member of various standing and non-standing committees of the Regional Council of the Institute.

He has also been the Secretary of the Regional Council of Northern India of the Institute of Chartered Accountants, for the year 1990-1991 & 1991-1992.
                  
Mr. M. K. AGARWAL..!

Mr. M.K. Agarwal is on the board of well reputed Public and Private Limited Companies in a professional capacity and also has been one of the Arbitrators of DSEA (Delhi Stock Exchange Association Ltd) in 1990

Mr. M. K. Agarwal is the founder Treasurer of Shri Agresen International Hospital, Pitampura & the Vice President of Bharat Vikas Parishad (North Delhi). Mr. M. K. Agarwal is the Senior Partner of the company and in that capacity looks after the entire range of practice relating to Audit, Direct Taxes including planning for corporate & non-resident Indians and rendering of Consultancy on Accounting, Company Law, Taxation, Capital market & FEMA matters.
Mahesh K. Agarwal & Co. is a professionally managed firm. 

The team consists of distinguished chartered accountants, corporate financial advisors and tax consultants. The firm represents a combination of specialized skills, which are geared to offer sound financial advice and personalized proactive services. Those associated with the firm have regular interaction with industry and other professionals which enables the firm to keep pace with contemporary developments and to meet the needs of its clients.




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